Keeping the Angels at Bay

Based on insights from

Based on insights from

For entrepreneurs who are eager to bring their new ideas to market, nothing gets the blood pumping like an early influx of cash. And with venture capital firms now waiting until later in a company’s development to invest large amounts—in part due to growing competition among early-stage funding sources—many startups rely on angel investors to get their business off the ground.

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In one sense, this new landscape is a blessing for startups: it has never been easier to reach a crowd of potential investors. But access to angels can also be a dangerous temptation.

“Angel investors are becoming a popular source of early-stage funding,” says Scott Baker, an assistant professor of finance at the Kellogg School. “That can be a positive thing, and for a lot of people, it’s hard to resist. But there are risks involved in accepting money from too many angels—it may not be to your long-term benefit.”

Baker sees three main reasons to be wary of accepting too much money from angels early on: it prevents a tangled investment structure that scares off venture capital; it helps entrepreneurs retain ownership of as much of the business as possible; and it keeps startups lean and disciplined.

“There are risks involved in accepting money from too many angels—it may not be to your long-term benefit.”

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Set yourself up for eventual VC investment. “There’s a reason why most startups seek investment from venture-capital firms,” Baker says.

Though these firms may charge fees and expect to own a sizeable chunk of an entrepreneur’s business, they can also help accelerate a company’s growth. “They have expertise, they can connect you to a vast network, and they are willing to offer guidance. You want to be able to leverage that experience and those connections.”

With angel investors, the capital often comes with less support. Angels, after all, are typically investing much smaller amounts and may not be able to provide the same range of expertise or operational assistance that a larger VC can.

That loss of support is compounded for startups that rely too heavily on a large group of angel investors. That is because a complicated ownership structure is an unpredictable ownership structure.

“VCs don’t like to deal with too many prior investors,” Baker says. “It’s hard to go to a board meeting and discuss voting rights if there are 20–25 different investors, each with a small stake.”

Avoid giving up too much equity. Tempting as early investment may be, it is important for startups to take a disciplined approach to raising capital. More investors mean more obligations; the founders also surrender equity with each new ownership claim. “The farther back you can push fundraising, that’s going to be beneficial in terms of how much of the company you keep.”

Bootstrapping is one way to avoid giving up equity. For startups offering a physical product, launching a campaign on a crowdfunding platform allows the business to bankroll itself while demonstrating viability to more serious investors. The Oculus Rift, a virtual-reality headset, was first introduced through a Kickstarter campaign back in 2012; the company is now owned by Facebook, and its groundbreaking product hit the market in March, to great fanfare.

Joining an incubator is another option for growing a young business. Incubators offer office rentals to select tenants that are then able to take advantage of mentorship, networking, and resource sharing with companies at similar stages. Startups can take advantage of these opportunities without giving up equity. Some companies working in incubators may also be chosen for accelerator programs, which provide funding to help companies that are close to launch.

Incubators have two additional advantages as well. First, a well-known incubator can offer a kind of certification. “The good ones can give you a gold seal, which will draw more attention from V.C.s later on,” Baker says.

Second, incubators are a good place to gain expertise. An incubator provides its startups help with legal processes, HR details, or web design—allowing those companies to offload aspects of the business that are not part of its core competency. The Chicago-based incubator Insight Accelerator Labs, for example, helps startups that have developed new medical devices commercialize their innovations.

Don’t always take the maximum amount. In the highly competitive, highly uncertain world of startup fundraising, there is a tendency to seek out the maximum investment available. Some founders might look at the amounts other companies have raised and think: we should be raising that much, too.

Baker says founders should focus more on mapping out their own growth projection and communicating that projection to investors.

“You should be clear about why you need a certain investment,” Baker says, “and it has to be something specific: ‘We need to expand this manufacturing facility; we need to hire these six people.’ Investors will always want to see a well-reasoned pitch.”

Maxing out may also lead young companies to become overambitious, funding questionable initiatives without aiming at profitability. Fab.com, which launched in 2011 as a daily deal site selling contemporary home furnishings, squandered its early investment on an over-the-top marketing campaign—the company sent new members at least one email a day—and ultimately failed to attract new customers.

Of course, the strategy for seeking investment will depend on the type of company, which is why Baker cautions against taking a one-size-fits-all approach to fundraising.

“How you go about raising money depends on a number of factors,” he says, including the industry, type of company, and founder’s level of expertise. It’s important to know up front what kind of overall support you need.

Still, it is worth keeping in mind the downside of too much angel investment.

“You might be the kind of entrepreneur who only needs capital,” Baker says.“But capital is easier to find than expertise and the kind of support that pays off in the long run.”